There are many elements from the new federal tax legislation that can impact state tax revenues. This is due to the degree of linkage between federal and state personal and corporate income tax laws. States have begun the thorny task of analyzing the possible implications to their state revenues, and to consider the range of state conformity actions they will choose to legislate. There will be a wide range of forecasted state revenue impacts primarily due to the degree that states tie their personal income tax codes to federal law, and the states’ level of reliance on personal income taxes in their revenue structures.
There is more variability in how states tie their personal income taxes to federal law than there is with their corporate income taxes. NASBO’s recent State Expenditure Report shows that personal income taxes make up 45.4% of state general fund revenues and corporate income taxes comprise 5.5%. Other sources of state general fund revenue, such as sales taxes, will not be directly impacted by the new federal tax legislation.
State Conformity to Federal Tax Laws
States choose how or whether they conform their income tax codes with key provisions of federal law. States do not tie their own tax rates to federal tax rates. States are in the process of forecasting what the new federal changes may mean, first by assuming no change in their own laws, or assuming that they alter the date by which they conform to the federal tax code. That process is a necessary and critical input into the choices about which portions of the federal tax law changes that states will consider tying to, or decoupling from, in their 2018 legislative sessions.
Timing of Conformity
Some state tax laws are set so that they automatically conform to certain federal income tax law changes unless they choose to specifically decouple through new legislation (18 states). Other states conform to the federal tax code on a fixed date (19 states). Four states tie to only selective federal income tax code provisions or some modified form of certain provisions.
Degree of Conformity – Starting Point – the Most Impactful Change
This relationship with the federal tax code is the most important variable that will determine the level of impact on state revenues of the tax legislation. Of the 41 states with a broad-based personal income tax, 31 states use federal adjusted gross income (AGI) or federal gross income (before itemized/standard deductions or personal exemptions) as a starting point for state personal income tax calculations. Five states (Colorado, Minnesota, North Dakota, Oregon, South Carolina) use federal taxable income (after itemized/standard deductions and personal exemptions) and will tend to have more potential impact from the federal tax legislation. Vermont recently changed its starting point for tax year 2018 from federal taxable income to adjusted gross income. Five states (Alabama, Arkansas, Massachusetts, New Jersey, and Pennsylvania) do not use a federal law-based starting point.
Impacts to State Revenue – Major Changes in the Federal Tax Legislation
This list is not exhaustive, but reflects a first look at the legislation’s provisions that could impact state revenues.
Personal Income Tax Provisions
There are major changes that will significantly modify the computation of taxable income that will flow through to state taxable income amounts under current state laws:
- eliminated (was $4,050 per individual in the 2016 tax year)
- almost doubled (coupled with limitations on itemized deductions, this will decrease the number of itemizers)
Itemized deduction changes
- a $10,000 limit on state and local tax deductions,
- reduction of the mortgage interest deduction for new loans from $1 million to $750,000,
- limiting the deduction for personal casualty and theft losses to losses incurred in a federally-declared disaster,
- suspending all miscellaneous itemized deductions that are subject to the 2% floor,
- increasing the AGI limitations on charitable cash contributions to 60% from 50%
- additionally, for tax years 2017 and 2018, lowering the AGI threshold for deducting qualified medical expenses from 10% to 7.5%.
Itemized Deductions and Standard Deduction – Potentially Large Impact
The changes made to the federal itemized deduction and standard deductions is the second-most important factor in determining the level of impact on state revenues of the tax legislation. Thirty-three states use or reference federal itemized deductions in some form to calculate state tax liability. Eight states conform with the federal standard deduction.
The various ways in which states tie to federal itemized deductions range from simple references to certain lines of the federal itemized deduction, Schedule A, to using total federal itemized deductions with the exclusion of state and local taxes. Some states use federal itemized deductions as a starting point with numerous additions and subtractions. Other states allow a deduction for the difference or a portion of the difference between federal itemized deductions and the state’s standard deduction or the federal standard deduction. The extent of that tie will significantly affect the impact on state income tax revenues.
Income Exclusions - Changes to Adjusted Gross Income (Above the Line)
The legislation eliminates through 2025 a few income exclusions that will result in an increase in the amount of AGI. These are also referred to as above the line deductions.
- Alimony received and paid
- Employment-related moving expense reimbursements by employers and moving expenses not reimbursed, with exception for members of the U.S. Armed Forces
- Bicycle commuting reimbursement
- Domestic production activities
Some States Allow Federal Income Taxes to be Deducted from State Taxes
There are six states that allow the deductibility of federal income taxes (Alabama, Iowa, Louisiana, Missouri, Montana, and Oregon) in their state tax codes. Some have exclusions or dollar limits. If federal taxes paid by those state taxpayers decline, state taxable income will be higher.
Child Tax Credit Changes
Many states have some link to the federal child tax credit. The legislation expands the child tax credit from $1,000 to $2,000 per child; $1,400 of the child tax credit would be refundable; the phase-out threshold of AGI is raised from $110,000 to $400,000 for joint filers; the earned income threshold for the refundable child tax credit is lowered from $3,000 to $2,500; and a social security number is required for each qualifying child.
Taxpayer Behavior - Will Some Income Deferrals from 2016 Show Up in 2017? Will Others Shift to 2018?
The federal tax legislation did not change the tax rate for capital gains. To the extent that some taxpayers deferred income subject to the capital gains tax from tax year 2016 to 2017 in anticipation of a lower future tax rate, states are examining whether they will see an uptick in estimated or final payments in the latter part of fiscal 2018.
With the drop in 2018 marginal tax rates, states will look into the prospect that non-wage income that is subject to ordinary income tax, instead of capital gains tax, may shift from the 2017 to the 2018 tax year.
Corporate Income Tax Provisions
Most states start the computation of state corporate tax income with federal taxable income. However, states do not conform to federal corporate income tax rates. According to the Tax Foundation, 44 states levy a corporate income tax, with 24 states using federal taxable income before net operating loss (NOL) and special deductions and 17 states using federal taxable income. The legislation includes a long list of limitations and eliminations of deductions, exclusions and credits. There are both federal tax revenue raisers and revenue losers, and states will examine the overall impact of these provisions on state corporate income tax revenues. States will have to consider the level of conformity they want in reviewing how these provisions would impact their state tax codes. The following are some of the changes that impact the computation of corporate income taxes:
- Expensing deduction – increasing the “bonus” depreciation to 100% and allowing taxpayers to write off immediately the cost of acquisitions of plant and equipment
- Interest deduction – new limits with exemption of certain small businesses, disallowing net interest expense in excess of 30 percent of the business’ adjusted taxable income
- Net operating loss – limit the carryover of net operating losses to 80% of taxable income and eliminate the carryback
- Deduction for income attributable to domestic production activities – repealed
- Business entertainment expenses – more limited
- Corporate Alternative Minimum Tax (AMT) – repealed
States will examine the possibility of a higher volume of business plant and equipment investment with the 100% expensing deduction in the near-term. That could have the effect of increasing sales tax receipts or shifting equipment purchases from future years to current periods. The level of increased activity in the current period could also lower corporate income tax liability in the near term and increase it in future years.
International Tax Changes – Repatriation of Holdings from Multinational Corporations
The federal tax legislation requires U.S. multinational corporations owning at least 10% of a foreign subsidiary to include as taxable income the U.S. corporation shareholder’s proportionate share of historical untaxed earnings and profits, the “deemed repatriation”, at 15.5% tax rate for cash holdings and 8% for noncash holdings. An election to make payment over eight years is permitted. The Federation of Tax Administrators has stated that 22 states conform to the federal treatment of “Subpart F” income, which will have an impact on which states may receive increased corporate revenues.
Estate and Gift Tax
There are other federal tax code elements that some states use as a starting point within their own tax code or add state tax credit enhancements based on a federal tax credit. The legislation doubles the exclusions of federal gift and estate tax. Delaware and Hawaii conform at the same level.
Health Insurance Premium Taxes
Some states will examine the potential impact on state health insurance premium taxes in light of the repeal of the individual mandate penalties (the excise tax imposed on individuals who do not obtain minimum essential coverage), with the expectation of a decrease in the number of insured individuals.
Impact on State Spending/Debt Issuance
There is one provision that impacts state spending, a section that repeals the most used tax-exempt debt refinancing tool, advance refunding bonds.
Tax-Exempt Debt Refinancing Repeal – Advance Refunding Bonds
Advance refunding bonds are used by state and local governments to obtain the benefit of lower interest rates when the outstanding bonds are not currently callable. The House bill eliminates advance refunding of tax-exempt debt. Based on an article from Bloomberg, advance refundings represent one-quarter to one-third of yearly tax-exempt municipal debt issuance. States used this tool in the past to manage their debt programs and it will no longer be available. For example, states used this tool to take advantage of lower interest rates, increase their debt capacity, and free up resources for infrastructure and other priorities.